NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach

Kenneth A. Froot, Jeremy C. Stein

NBER Working Paper No. 5403
Issued in January 1996
NBER Program(s):   AP   CF

We develop a framework for analyzing the capital allocation and capital structure decisions facing financial institutions such as banks. Our model incorporates two key features: i) value-maximizing banks have a well-founded concern with risk management; and ii) not all the risks they face can be frictionlessly hedged in the capital market. This approach allows us to show how bank-level risk management considerations should factor into the pricing of those risks that cannot be easily hedged. We examine several applications, including the evaluation of proprietary trading operations, and the pricing of unhedgeable derivatives positions.

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Document Object Identifier (DOI): 10.3386/w5403

Published: Journal of Financial Economics (1998).

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